Starting in 2014 ag commodities and the global economy went through a rough patch that most would say stemmed from oversupply. The U.S. dollar gained steam against other major currencies. We also saw oil and agricultural prices freefall, along with several other macroeconomic events.
Conventional wisdom suggests the movement of the U.S. dollar has an inverse relationship to the price of imports and in this case, a strong U.S. dollar decreases the price of imports. Anyone growing row crops has a general understanding of this as the U.S. is expected to export $164 billion this year, up from $135.7 billion last year.
However, import prices of consumer discretionary goods don't always move in sync with changes in the U.S. dollar, as foreign firms often choose to maintain their prices in the U.S. market. Instead, the connection between import prices and the U.S. dollar is reflected by the tendency for commodity prices to fall when the dollar strengthens. Commodity markets are quoted in U.S. dollars so it may seem intuitive that when the dollar rises, commodity prices will decrease. Easily, a stronger U.S. dollar will impact inflation through commodity prices rather than consumer goods. So, a key factor to consider in anticipating how the currency will affect inflation is the behavior of commodity prices.
Commodity prices are believed to be a leading marker of inflation through two basic outlets. Leading indicators often exhibit measurable economic changes before the economy as a whole does. One theory suggests commodity prices respond quickly to general economic shocks, such as increases in demand. The second is that changes in prices reflect systemic shocks, such as hurricanes, which can decimate the supply of agricultural products and subsequently increase supply costs. By the time it reaches consumers, overall prices would have increased, and inflation would be realized.
The strongest case for commodity prices as a leading indicator of expected inflation is that commodities respond quickly to widespread economic shocks. Most would argue this is exactly what we are seeing today.
Whether it’s unique shocks or general price movements, the commodity-inflation relationship doesn't always hold. For example, an increase in the total demand for final goods and services can coincide with an increase in demand for manufactured goods relative to agricultural products. While this could lead to a rise in overall prices, prices of agricultural commodities might fall.
These types of occurrences suggest that commodity-inflation movements depend on what is driving the commodity change. Moreover, a stronger dollar in the global market will increase the price of commodities relative to foreign currencies. The higher price of commodities in foreign currency will work to lower demand and dollar-priced commodities. In this scenario, increasing commodity prices abroad could cause domestic deflation.
Looking at history, the simple two-way relationship between commodity prices and inflation has significantly declined over time. In the 1970s, the relationship was statistically and evidently robust. However, in the past 30 years, the correlation has become less significant. Commodity prices performed well as an indicator of inflation when other factors influencing inflation, like employment and exchange rate fluctuations, were apparent.
Globalization has increased the interconnectedness of economies, and when commodity prices increase from a strong dollar, this typically results in domestic deflation. While commodity prices are not 100% indicative of inflation, they can be a good starting point when attempting to hedge against inflation. Therefore, we should see such a large appetite of money flow coming into the agricultural market sector as it diversifies portfolios in the event of inflation.
The main messages are still valid, though. The macroeconomic rally is due to a combination of demand-side factors:
- Economic reopening, with a particularly strong revival in industry;
- Supply-side factors (reduction in inventories); and
- Financial elements (increased appetite for risk and depreciation of the dollar).
Although I consider myself more of a fundamentalist, agricultural markets/prices have external forces that we don’t always consider when looking at the big picture. We all know that adage, “markets can act irrational, longer than most can stay solvent.” I believe inflation, currencies and supply chains will play a larger role in the day-to-day price fluctuations into the end of the year and certainly into 2022. Be diligent with your risk management and find a trusted advisor.
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